‘America first’ will guide the Fed’s monetary policy, despite emerging markets’ rate hike concerns

Neal Kimberley says other central bank heads, including in Indonesia and India, may not be thrilled with the effect the Fed’s actions are having on their stock and bond markets, but the US central bank sees data supporting its decision to raise rates again this week – and possibly up to four times this year

PUBLISHED : Tuesday, 12 June, 2018, 12:04pm
UPDATED : Tuesday, 12 June, 2018, 10:30pm

It might not be what some policymakers in Asia would like, but the US Federal Reserve will almost certainly raise US interest rates again on Wednesday and there is a material risk that a quarterly update to its “Summary of Economic Projections” will point to four hikes in 2018 rather than March’s projected three.

And this would be in addition to the US central bank’s continuing implementation of quantitative tightening and the greater issuance of government paper by the US Treasury as a consequence of the Trump administration’s fiscal policies.

Some policymakers in Asia would like the Fed to think about the wider consequences of its actions. “We know every country must decide their policy based on domestic circumstances but look, you have to take account of your actions and the impact of your actions to other countries, especially the emerging markets”, Perry Warjiyo, Indonesia’s central bank chief said last Wednesday, with the US central bank clearly in mind.

With the rupiah having struggled on foreign exchanges this year, Indonesia raised interest rates twice in May, to 4.75 per cent but, as Warjiyo’s comments attest, how the Fed moves is also critical to the Indonesian economy and its currency.

Elsewhere, India raised its benchmark repo rate by 25 basis points last Wednesday to 6.25 per cent. The Reserve Bank of India (RBI) was responding, as governor Urjit Patel said, “to the risks to [the] inflation target that have emerged in recent months”. Those risks would include a rise in energy prices and to a broader increase in imported inflationary pressures caused by Indian rupee weakness.

Yet, Patel also has an eye on US monetary policy, writing last week in The Financial Times, how US “dollar funding of emerging market economies has been in turmoil for months now”, a situation the RBI governor attributes not to Fed rate hikes but to its “long-awaited moves to trim its balance sheet and a substantial increase in issuing US Treasuries to pay for tax cuts”.

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This coincidence of factors, Patel contends, “has proved to be a ‘double whammy’ for global markets”.

Certainly, capital has been exiting emerging market economies. Data from the Institute of International Finance for May showed they experienced a combined US$12.3 billion of outflows in bonds and stocks last month. With that scale of global emerging market capital outflow, it’s easy to see why countries such as India and Indonesia, as well as others such as the Philippines and Turkey, have had to hike domestic rates recently.

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As for where capital is heading, data last Thursday from Lipper, a unit of Thomson Reuters, provides some clue. In the week ending June 6 alone, US-based money market funds saw inflows of nearly US$34.9 billion as investors worldwide were drawn to the combination of higher US yields and perceived lower risk.

To alleviate the situation, Patel would like the Fed to recalibrate the pace of its balance sheet reduction to offset the impact of the US Treasury’s increased issuance.

It remains to be seen if it will heed the calls of policymakers such as Patel and Warjiyo – but the odds are against.

“There is good reason to think that the normalisation of monetary policies in advanced economies should continue to prove manageable for [emerging market economies]”, said Fed chief Jerome Powell on May 8.

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Meanwhile, on May 31, Fed governor Lael Brainard argued that “in an environment of tightening resource utilisation and above-trend growth, with sizeable fiscal stimulus likely to provide a boost to demand in the near-to-medium term that should fade somewhat further out, it seems likely that the neutral rate could rise in the medium term above its longer-run value”.

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Far from seeing Trump’s fiscal policy as a reason, as Patel suggests, for the Fed to scale back the pace of its quantitative tightening, Brainard would seem to see it as justifying yet tighter US monetary policy overall.

From a domestic US perspective, as US bank BNY Mellon’s Marvin Loh noted on Friday, “data has recently been supportive of the Fed’s economic projections”. And this is before the full impact of Donald Trump’s tax cuts has arguably been seen.

The Fed might realistically interpret the Trump tax cuts as the equivalent of throwing petrol on an already lit fire, and move to douse the flames.

It’s unlikely the Fed will be so concerned about the international impact of its monetary policy settings that it will affect its decision-making. In US monetary policy, as in the Trump White House, it will be “America first”.

Neal Kimberley is a commentator on macroeconomics and financial markets